Benchmark interest rates when the government is risky

Mikhail Chernov, Patrick Augustin, Lukas Schmid and Dongho Song

No 14105, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Since the Global Financial Crisis, rates on interest rate swaps have fallen below maturity matched U.S. Treasury rates across different maturities. Swap rates represent future un- collateralized borrowing between banks. Treasuries should be expensive and produce yields that are lower than those of maturity matched swap rates, as they are deemed to have supe- rior liquidity and to be safe, so this is a surprising development. We show, by no-arbitrage, that the U.S. sovereign default risk explains the negative swap spreads over Treasuries. This view is supported by a quantitative equilibrium model that jointly accounts for macroeco- nomic fundamentals and the term structures of interest and U.S. credit default swap rates. We account for interbank credit risk, liquidity effects, and cost of collateralization in the model. Thus, the sovereign risk explanation complements others based on frictions such as balance sheet constraints, convenience yield, and hedging demand.

Keywords: Sovereign credit risk; Negative swap rates; Recursive preferences; Term structure (search for similar items in EconPapers)
JEL-codes: C1 E43 E44 G12 H60 (search for similar items in EconPapers)
Date: 2019-11
New Economics Papers: this item is included in nep-mac
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Citations: View citations in EconPapers (2)

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Journal Article: Benchmark interest rates when the government is risky (2021)
Working Paper: Benchmark Interest Rates When the Government is Risky (2019)
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